How Taxation of Life Settlement Proceeds Works Now

Tax season has come again.

One question that frequently arises about the secondary market for life insurance is: How are the proceeds of a life settlement taxed?

The answer: Well, it isn’t straightforward.

However, it’s a critical question as the amount of tax owed on a payment could significantly impact the assessment of whether or not an individual should sell a policy.

First and foremost, we always recommend that anyone who sells a life insurance policy into the secondary market should seek the advice of an accountant or tax expert.

Given that, here is some essential background regarding taxation to help serve as unofficial guidance.

 Taxes on ‘Found Money’

Before getting into the specifics of taxation, it’s important to note that if an insured sells a policy that would otherwise lapse, the tax consequences are less meaningful.

The funds from the settlement, essentially “found money,” wouldn’t exist without the settlement.

Even if the payment were heavily taxed, it would still be a better deal than letting a policy lapse and receiving nothing in return.

We would all rather pay taxes on found money than receive nothing.

The Health Status of the Insured

One of the first questions that should be addressed about taxation of life settlement proceeds is the health status of the insured who’s selling the policy.

If the insured is terminally ill, which means they have a life expectancy of fewer than two years, the settlement proceeds will be tax-free.

Technically, the transaction will be called a viatical settlement if the insured is terminally ill, and this has a different tax treatment from a life settlement transaction.

The IRS defines a terminally ill person as “someone who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 24 months or less after the certification date.”

In addition, if the insured is chronically ill, the settlement proceeds may not be taxed.

The IRS defines a chronically ill individual as “someone who has been certified (at least annually) by a licensed health care practitioner as being unable to perform, without substantial assistance from another individual, at least two daily living activities (eating, toileting, transferring, bathing, dressing, and continence) for at least 90 days due to a loss of functional capacity.”

Or a person “requiring substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment.”

The settlement proceeds will not be taxed if the insured is terminally ill or chronically ill by IRS standards.

Traditional Life Settlements

Taxation of a traditional life settlement is more complex.

Essentially there are three tiers of taxation.

The first tier is tax-free. Any proceeds obtained from the settlement, up to your tax basis, are not taxable. This would include premiums paid into the life insurance policy.